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SHARIAH COMPLIANT ETF WITH CLIMATE RISK MITIGATION
Abstract
Climate change has become a pressing issue for the investment industry, with many funds exposed to the risk of disruptions caused by a transition to a low-carbon economy. This is particularly true for Shariah-compliant index funds, which tend to have higher carbon intensity levels. In light of these circumstances, the goal of the present thesis is to investigate the feasibility of reducing the carbon footprint of a Shariah-compliant ETF while minimizing the annualized tracking error. Utilizing the methodology proposed by Andersson et al. (2016), this study demonstrates that it is possible to achieve a 46% reduction in carbon intensity over a 7-year period, while maintaining a low annualized tracking error of 0.12%, similar annualized volatility to the benchmark, and improved annualized returns.
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This research project is both an update of the analysis on carbon emissions trajectories proposed by Le Guenedal et al. (2020) and a companion study of the climate risk measures defined by Le Guenedal and Roncalli (2022). While Le Guenedal et al. (2020) use carbon intensities, we extend the track-record projection approach by considering absolute carbon emissions. In particular, we propose a carbon budget approach that incorporates novel metrics for measuring the carbon emissions reduction targets and the relative positioning with respect to the net zero emissions (NZE) scenario. Indeed, current carbon emissions data are not sufficient to build portfolio alignment. The purpose of this paper is then to define net zero carbon metrics, which are necessary to enhance the disclosure and the debate on corporates' emissions (Créhalet, 2021; Le Meaux et al., 2021). These carbon metrics can be divided into two families. The static measures are NZE duration, NZE gap, NZE slope and NZE budget. They can be computed using a target scenario or the linear trend model. The dynamic NZE measures incorporate the past trajectory and the future scenarios of carbon emissions. For instance, we break down the carbon budget by error and revision time contributions. We also propose a velocity measure of the carbon emissions trend and two main dynamic NZE measures that are necessary to assess the performance of an issuer compared to the NZE scenario: the zero-velocity scenario and the burnout scenario. These different measures can then be used to define the PAC framework, that analyzes the participation, ambition and credibility of issuers' NZE policies. Finally, we apply this framework to the CDP database. Empirical results show that net zero carbon emissions are challenging for many issuers for two reasons. The first is that some issuers have a lack of ambition concerning their NZE scenario. The second is that some targets are not compatible with past trends.
Because of the 2015 Paris Agreement, the development of ESG investing and the emergence of net zero emission policies, climate risk is certainly the most important topic and challenge for asset owners and managers now and will remain so over the next five years. It considerably changes portfolio allocation and the investment framework of both passive and active investors. The goal of this paper is to conduct a survey of the various climate risk measures that are available in the asset management industry and the practices of portfolio construction that use these metrics. Therefore, the first part of this paper lists the different climate risk metrics -- e.g., carbon footprint, carbon transition pathway, carbon transition and physical risks. The second part is dedicated to portfolio optimization, in particular portfolio decarbonization and portfolio alignment (Paris-based benchmarks and net zero carbon objective). Among the different findings, two are of great importance for investors. First, portfolio decarbonization is more difficult when we include scope 3 carbon emissions. Indeed, optimizing using the sum of scopes 1, 2 and 3 emissions leads to a portfolio with more tracking error risk than using direct plus first tier indirect carbon emissions. Second, portfolio alignment is more complex than portfolio decarbonization. Since aligning portfolios with scope 3 is becoming the standard approach to climate portfolio construction, the impact on portfolio management may be substantial, and the divergence between carbon investing and traditional investing will increase.
In this paper, we build portfolios with decreasing carbon footprint, which passive investors can use as new Paris-consistent (PC) benchmarks and have the same risk-adjusted returns as business as usual (BAU) benchmarks. As the distribution of firms' carbon intensity is very skewed, excluding a small fraction of highly polluting firms can massively reduce the carbon footprint of a portfolio of corporate stocks. We identify the worst polluters globally, exclude them from the portfolio, and re-allocate the proceeds so as to keep sectoral and regional exposures similar to those of the business as usual (BAU) benchmark. This approach limits divestment from corporates in Emerging Countries that would result from implementing exclusions and reinvestment without the objective of preserving regional exposures. We show that reducing the carbon footprint of the portfolio by 64% in 10 years would be obtained by excluding sequentially up to 11% of the corporates, which together amount to less than 6% of the global market portfolio. While this reallocation preserves regional and sectoral exposures similar to those of the BAU benchmark, it does not change its risk-adjusted return. We de ne PC benchmark portfolios at the global level, for Emerging Countries, Europe, North America, and the Pacific.
ESG investing has gained considerable traction over the past few years and, alongside smart beta, factor investing and alternative risk premia, is one of the current hot topics for the asset management industry. Nevertheless, even though large institutions such as insurance companies, pension funds and sovereign wealth funds have invested significantly in ESG strategies over recent years and we are observing a substantial and increasing interest from other investors such as wealth management or retail investors, the question of performance remains a controversial issue and a puzzle for the financial community. Indeed, academic findings have been mixed and have revealed a U-shape pricing of stocks in the equity market, meaning that both best-in-class and worst-in-class ESG stocks have been rewarded by the equity market in the past. In this research, we analyze the relationship between ESG and performance in the recent years (2010 – 2017) since ESG was more an anecdotal and explanatory investment idea before the Global Financial Crisis. For that, we consider different regions (North America, Europe, Japan, World) and different investment styles (passive management, active management and factor investing). We show that ESG investing has been rewarded since 2014, but not before. Across the three ESG pillars, the Environment factor in North America and the Governance factor in the Eurozone performed the strongest. Overall, the study reveals that ESG does not impact all stocks, but tends to impact best-in-class and worst-in-class assets. Contrary to common beliefs, we also observe that ESG had little impact on volatility and drawdown management during the 2010-2017 period. In the case of passive management, implementing an ESG strategy helps to improve the information ratio if the investor accepts to take a tracking error risk. Finally, we show that ESG investing is related to factor investing. In particular, we conclude that ESG investing remains an alpha strategy in North America, whereas it has become a beta strategy in the Eurozone.
Of the 17 Sustainable Development Goals (SDGs) of the United Nations, the first 11 relate directly to Islamic economics and finance. Indeed, they are a perfect fit with the purpose and principles of Islamic finance. Moreover, the Islamic finance industry has contemporary products to address these SDGs. This paper presents current product development and implementation examples of Islamic finance in the context of SDGs. In this regard, success with SDGs can be attained through resource mobilization. Reality suggests that such mobilization requires product development and successful SDG programs. Further, in order to attract resources, SDG programs need to provide convincing results. The most effective programs, as presented in this paper, should be financed with suitably employed resource mobilization tools. Islamic finance can address the first 11 SDGs by harnessing modern resource mobilization products to these programs.
This study explores the potentials of SRI sukuk as a source of financing for projects that address community and social issues, thus giving positive impact to the society. Focusing on several cases of SRI sukuk in critical yet not so commercially-attractive for profit-motivated financial institutions to participate in such as education, environment and health sectors, this study highlights the mechanisms and challenges as well as potentials of SRI sukuk as a source of financing for these projects. Since the field of SRI sukuk is still in its infancy stage especially in Islamic finance, this study hopes to contribute towards enriching the literature as well as exploring the potentials for further applications in other areas in the Islamic finance industry.
We present a simple dynamic investment strategy that allows long-term passive investors to hedge climate risk without sacrificing financial returns. We illustrate how the tracking error can be virtually eliminated even for a low-carbon index with 50% less carbon footprint than its benchmark. By investing in such a decarbonized index, investors in effect are holding a "free option on carbon." As long as climate change mitigation actions are pending, the low-carbon index obtains the same return as the benchmark index; but once carbon dioxide emissions are priced, or expected to be priced, the low-carbon index should start to outperform the benchmark.
Building on Barnett’s (2007) theoretical argument that a firm’s ability to profit from social responsibility depends upon its stakeholder influence capacity (SIC), we bring together contrasting literatures on the relationship between corporate social performance (CSP) and corporate financial performance (CFP) to hypothesize that the CSP-CFP relationship is U-shaped. Our results support that hypothesis. We find that firms with low CSP have higher CFP than firms with moderate CSP, but firms with high CSP have the highest CFP. This supports the theoretical argument that SIC underlies the ability to transform social responsibility into profit.
Purpose
The purpose of this paper is to analyze the impact of applying alternative Shariah screens on the resulting universe of halal assets and to show that Shariah screening procedures currently used in practice are inconsistent with respect to discriminating between halal and haram.
Design/methodology/approach
An empirical data analysis of the different asset universes obtained when applying the criteria specified by the most prominent Shariah‐compliant funds and indexes to a common standard asset universe, the assets contained in the S&P 500 index.
Findings
Analysis reveals that the asset universes are significantly different in size as well as constituents, i.e. for every index there is a substantial number of assets which are specified as halal or haram but classified the opposite way for other indexes. This indicates that, so far, there is no universal or generally accepted understanding of how to transform the descriptive Shariah rules into a system of checkable investment guidelines.
Research limitations/implications
The results presented in this paper could motivate the development of a standardized screening framework which, taking into account the existing Shariah guidelines, produces a controlled, unified and understandable classification of assets, by which the credibility and consistency of Islamic equity products is enriched.
Practical implications
Islamic institutions and Shariah scholars are guided to set up a common and standardized Shariah screening norm based on which computer‐based management systems for Shariah compatible portfolios could be developed.
Originality/value
This paper is believed to be the first empirical comparative analysis identifying the impact of using different Shariah screens on the composition of the compliant asset universe. The sensitization of Shariah scholars, fund managers and Islamic investors for the consequences of this so far undiscovered relation will certainly contribute to an enrichment of the credibility and consistency of Islamic equity products.
This paper looks at whether the tenets of Islam are consistent with the ‘Ten Principles’ of responsible business outlined
in the UN Global Compact. The paper concludes that with the possible exception of Islam’s focus on personal responsibility
and the non-recognition of the corporation as a legal person, which could undermine the concept of corporate responsibility,
there is no divergence between the tenets of the religion and the principles of the UN Global Compact. Indeed, Islam often
goes further and has the advantage of clearer codification of ethical standards as well as a set of explicit enforcement mechanisms.
Focusing on this convergence of values could be useful in the development of a new understanding of CSR in a global context
and help avert the threatened “clash of civilisations”.
KeywordsCSR-Islam-UN Global Compact-Environment-human rights-labour rights
This book is the first of its kind to provide a critical overview and theoretical analysis of the Circular Economy from Shariah and Islamic Finance perspectives. The book is divided into three parts. The contributing authors pay close attention to Islamic Finance in light of sustainability and value creation. It also includes case studies on the Circular Economy application in Islamic Finance industry. The book is of interest to academics, students, and practitioners on Islamic Economics and Finance who have an interest in understanding the Circular Economy under the lens of Islamic Finance principles and applications.
Using a large and extended global dataset of non-financial firms (4,624 listed entities from 2002 to 2018), we provide the first empirical evidence on how ESG and Sharia screenings interact and influence market risks. We link two contrasting literature streams: the risk reduction role that the stakeholder theory attributes to ESG scores, and the opposite effect for Sharia-compliance anticipated by the portfolio and agency theories.
We find that when ESG scores are not considered, Sharia certification increases risks. We also prove that engagement in sustainable activities mitigates risks for both Sharia-compliant and conventional firms. More interestingly, we show that Sharia-compliant firms obtain a larger risk-mitigating effect for greater levels of ESG scores. These results are robust to endogeneity and to extensive additional checks.
Our findings validate the hypothesized complementarity between ESG and Sharia screenings.
We study whether carbon emissions affect the cross-section of US stock returns. We find that stocks of firms with higher total carbon dioxide emissions (and changes in emissions) earn higher returns, controlling for size, book-to-market, and other return predictors. We cannot explain this carbon premium through differences in unexpected profitability or other known risk factors. We also find that institutional investors implement exclusionary screening based on direct emission intensity (the ratio of total emissions to sales) in a few salient industries. Overall, our results are consistent with an interpretation that investors are already demanding compensation for their exposure to carbon emission risk.
We examine the decoupling and contagion hypotheses by testing them on the safe haven status of Islamic indexes through investigating the total, directional and net volatility spillovers across nine regional Islamic stock indexes and their conventional counterparts, using the generalized vector autoregressive framework. We use daily data covering the period 1999 to 2014 which includes various financial crises such as those that took place in Asia, Russia, Argentina, Brazil and the United States. The results show that global financial crises strongly affect the cross-market volatility. Although the contagion hypothesis is evident for both Islamic and conventional indexes, the findings also suggest the presence of a decoupling of the Islamic indexes from their conventional counterparts during turbulent periods. The results provide several useful implications for policy makers and portfolio managers seeking to diversify their portfolios and to hedge market risk, confirming that the Islamic financial indexes are a safe haven for investors during financial crises. Furthermore, paper reports significant time-varying patterns in the volatility spillovers for all the Islamic and conventional stock indexes and points out the stress transmitters and receivers.
Positive ethics associated with socially responsible investments (SRI) is challenging the limits of Islamic investments' conservative approach to promote corporate social responsibility. In this study, we test the integration of social performance measures (companies the most virtuous or high-rated in terms of Environmental Social and Governance (ESG) issues) in Islamic portfolios using KLD social ratings. We seek to determine the financial price of complying both to Islamic investment and SRI principles. To do so, we measure the financial performance of self-composed Islamic portfolios with varying ESG scores. The results indicate no adverse effects on returns due to the application of ESG screens on shariah-compliant stocks during the 2007–2011 periods while reporting substantially higher performance for the portfolios with good records in governance, products, diversity and environment issues. On the opposite, a negative performance is associated with an SRI strategy of disengagement from shariah-compliant stocks with community and human rights controversies. Our performance measures are controlled for market sensitivity, investment style, momentum factor and sector exposure.
Can environmental, social and governance (ESG) performance be a
criterion for Islamic investment policies? The development of
socially responsible investments (SRI) challenges the conservative
approach of Islamic investments toward promoting corporate
social responsibility. This study therefore tests the potential of
integrating positive ESG screening with Islamic portfolios using
KLD social ratings, to determine the financial price that shariah
compliance and social responsibility entail. Our results reveal no
adverse effects on returns due to the application of Islamic and
ESG screening; substantially higher performance results from the
inclusion of good governance criteria in the post-subprime crisis
period.
This paper investigates the co-movement of nine Islamic Exchange Traded Fund (ETF) returns using wavelet coherence methods. The results tend to indicate consistent co-movement between most of the ETF returns especially in the long run. The study also uncovers evidence of wide variation of co-movement across the time-scales during the global financial crisis and the Euro debt crisis. Strong co-movement can be observed during the global financial crisis, both for the medium term investors and long term investors. The paper also studies the relationship between different ETF returns using wavelet multi-resolution analysis. The cross-correlation analysis also shows certain significant and positive correlations between the ETF returns, especially during the period of global financial crisis. The findings from these two recent dynamic time-scale decomposition methodologies have important policy implications for risk management and investors' investment policy.
Institutional investors wanting to integrate Environmental, Social and Governance (ESG) factors in their investment strategies need the right tools to measure portfolio risk characteristics and performance. MSCI’s BarraOne and Barra Portfolio Manager can provide this utility with Intangible Value Assessment (IVA) ratings from MSCI ESG Research. In this study, we examine the use of IVA ratings with the Barra Global Equity Model (GEM3) to build optimized portfolios with improved ESG ratings, while keeping risk, performance, country, industry, and style characteristics similar to conventional benchmarks, such as the MSCI World Index. The currently available dataset of IVA scores allowed us to compare three strategies during the period between February 2008 and December 2012, using current IVA ratings methodology. Of the three strategies, we found the best active returns during this period were achieved by overweighting firms whose IVA ratings improved over the recent time period, showing ESG momentum. Underweighting assets with low ESG ratings also raised portfolio performance during this period. The highest ESG rated assets had more uneven performance; they generally did better in periods of limited risk appetite during this volatile market cycle.
The aggressive manipulation of the natural resources in Kuwait and the destruction of the southern Arab marshes in Iraq, are two recent environmental disasters in the Arabian Gulf region. This paper elaborates some important principles of environmental ethics in Islam and shows some examples for which development of new Islamic thoughts in environmental ethics seems to be essential. As there are common futures with shared possibilities and common threats with equivalent adverse outcomes, the whole process of self-correction needs the input of the West and of Christian views on the environment also. Given the global impact of the environmental crisis, international cooperation is urgently needed to avert environmental dangers which need not arise and environmental dangers which already exist but which must be mitigated and avoided.
Defining social investing and its boundaries is a challenging task, since no general consensus exists about the ‘ideal’ characteristics that socially responsible investments (SRIs) should possess. Some faith-based investments, for instance, Islamic funds, are often associated with SRIs, even if there are some inconsistencies in the investment decisions. This paper explores whether Islamic investments can be included into the category of SRIs or whether they exhibit characteristics that would more fittingly classify them in a separate investment family. To answer this research question, we focus on equity investments from both a qualitative and a quantitative point of view. The first part of the study discusses and compares the screens generally used to build socially responsible (SR) and Islamic portfolios, while the quantitative section of our study analyses portfolios’ characteristics using relevant European indices as a proxy for SRI and Islamic funds. Covering the period from 2001 to 2011, we use style analysis to investigate the sector and country composition of SR and Islamic portfolios. In addition, through a cointegration analysis on FTSE indices, we show that the econometric profile of the FTSE Islamic series exhibits peculiar portfolio characteristics compared to conventional and SRI indices. Although the academic literature has extensively analysed SRIs and some authors have focused on Islamic investments, to the best of our knowledge, this is the first paper to investigate the qualitative and econometric differences between SRIs and Islamic investments.
Purpose
The governance structure of Islamic financial institutions (IFIs) implements Islamic canon law ( Shari'a ) into business transactions through Shari'a supervision processes. This paper aims to define Shari'a supervision and examine Shari'a supervisory councils (both within and outside the Central Bank), Shari'a consulting firms, Shari'a advisors, and Shari'a Supervisory Boards (SSB). It also discusses the importance of the hierarchical position of SSBs and evaluates their objectives and functions.
Design/methodology/approach
The paper reviews a wide range of theoretical literatures especially recent proceedings of relevant conferences in the Gulf Cooperation Council (GCC) countries along with the standards of the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI). A framework for understanding the role of the SSB is developed suggesting a set of objectives and functions for the SSB.
Findings
The paper finds a lack of standardization among the IFIs concerning the position of the SSB within the corporate hierarchy. Moreover, the SSB is found to control the IFIs activities more than the other types of Shari'a supervision such as Shari'a consulting firms and Shari'a advisors.
Research limitations/implications
The research focuses exclusively on the GCC countries and excludes the other Middle East and Far East countries where Shari'a supervision might have different forms.
Social implications
The research provides guidelines for IFIs in defining the SSB role in their governance structure and recommends the SSB among the other forms of Shari'a supervision ( Shari'a consulting firms and Shari'a advisors) in controlling the IFIs activities.
Originality/value
This study contributes to the literature gap about the governance of IFIs. It is one of the first studies that provide a conceptual foundation for the SSB role in the governance structure of IFIs.
As global business operations expand, managers need more knowledge of foreign cultures, in particular, information on the ethics of doing business across borders. The purpose of this paper is twofold: (1) to share the Islamic perspective on business ethics, little known in the west, which may stimulate further thinking and debate on the relationships between ethics and business, and (2) to provide some knowledge of Islamic philosophy in order to help managers do business in Muslim cultures. The case of Egypt illustrates some divergence between Islamic philosophy and practice in economic life. The paper concludes with managerial implications and suggestions for further research.
The Sustainable Development Goals and The Role of Islamic Finance
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ESG and Islamic Finance: An ethical bridge built on shared values
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